Phoenix Companies Inc. Q3 2009 Earnings Call Transcript

Nov. 3.09 | About: The Phoenix (PNX)

Phoenix Companies Inc. (NYSE:PNX)

Q3 2009 Earnings Call

November 3, 2009 11:00 am ET

Executives

Naomi Kleinman – Investor Relations

Jim Wehr – Chief Executive Officer

Peter Hofmann – Chief Financial Officer

Chris Wilkos – Chief Investment Officer

Phil Polkinghorn – Senior Executive Vice President for Life and Annuity

Mike Hanrahan – Chief Accounting Officer

Analysts

Bob Glasspiegel – Langen McAlenney

Jimmy Bhullar – JP Morgan

Eric Berg – Barclays Capital

Steven Schwartz – Raymond James & Associates

Amanda Lynam – Goldman Sachs

Operator

Welcome to the Phoenix Companies third quarter 2009 earnings conference call. Thank you for standing by. (Operator Instructions). I will know turn the call over to the head of Phoenix Investor Relations, Naomi Kleinman, you may begin.

Naomi Kleinman

Good afternoon and thank you for joining us. I'm going to start with the required disclosures and then turn it over to Jim Wehr, our president and CEO, for an overview of the quarter. With us today are Peter Hofmann, chief financial officer, Phil Polkinghorn, senior executive vice president for Life and Annuity, Chris Wilkos, chief investment officer and Mike Hanrahan, chief accounting officer.

Our third quarter earnings release, our quarterly financial supplement and the third quarter earnings review presentation are available on our website at phoenixwm.com. Slide two of the presentation contains the important disclosures.

We may make forward-looking statements on this call that are subject to certain risks and uncertainties. These risks and uncertainties are discussed in detail in our third quarter earnings release and our latest SEC filings. Our actual results may differ materially from such forward-looking statements.

In addition to generally accepted accounting principles we use non-GAAP financial measure to evaluate our financial results. Reconciliations of these non-GAAP financial measures to the applicable GAAP measures are included in our press release and financial supplement.

Now, I will turn the call over to Jim.

Jim Wehr

Good afternoon and thank you for joining us for our report on the third quarter. We will follow are usual format. I will give a high level overview of the quarter, Peter will provide the financial details and Chris will do the same for the investment portfolio. Then we will take questions.

I want to begin by summarizing the quarter and where we are in our effort to right our ship. We had a net loss of $26.6 million and an operating loss of just under $3 million. After excluding unusual items we had operating income of more than $33 million. We believe the third quarter results indicate we have turned the corner on many key metrics that are showing signs of solid improvement.

The continuing focus on our four strategic pillars, a healthy balance sheet, policyholder security, expenses and a sustainable growth strategy is having the intended impact providing Phoenix with enhanced financial strength and flexibility as we move forward.

I do not want to overstate things because results are not where we want them to be or have the potential to be. However, as we've said before, Phoenix is a work in progress and we continue to make progress. As further evidence by today's announcement of our new distribution company Saybrus Partners.

Let's now look at some of the specifics of the quarter that lead me to make these statements. I'll begin with our core operating fundamentals which were stronger in the quarter, including improved investment performance and mortality experience. Expense reductions began to have an impact and surrenders remained at manageable levels. I'll touch on each of these.

We are pleased with our investment portfolio's performance, although I am not surprised. We believe the reason it was able to weather the financial storm of the last year is that it was well constructed and has been carefully managed by an experienced investment team. Net and unrealized losses improved by almost $700 million during the quarter.

Gross credit impairments were just under $15 million, down from about $21 million in the second quarter, $38 million in the first quarter and $138 million in the fourth quarter of 2008. We also saw a turnaround in the alternative investment classes with venture capital, mezzanines and private equity generating positive earnings for the quarter.

We believe these improvements point to a positive trajectory for the portfolio going forward. Chris will provide more details in a few minutes, including that we have resumed a more typical new money investment strategy while maintaining an enhanced liquidity level. Another significant improvement in our fundamentals in the quarter was mortality which was improved across all product lines and modestly better then long-term expectations.

A strong quarter like this affirms that our disciplined underwriting process is sound. Expenses in the quarter, both incurred and deferred, began to benefit from our cost reduction initiatives. We expect to see further run rate improvement on expenses in the fourth quarter. Our expense reductions were responsible reaction to lower revenue. While we cut expenses in all areas of the company, a significant portion took place in areas associated with the acquisition of new business.

In periods when we had higher sales those expenses would have been deferred. Now, however, deferrable expenses are much lower. Surrender activity remained at manageable levels in the quarter. Life surrenders we had an annualized rate of 10% for the third quarter, slightly elevated but again manageable. Annuity surrenders also came in an annualized rate of 10% much improved from the first and second quarters. We continue to employ an active policyholder and producer outreach effort.

Peter and I have had a number of calls and meetings with producer groups in the last six months. We spend a majority of these meetings reviewing our financials with particular emphasis on the balance sheet. It is our belief that facts can help temper emotions and to that end we continue to hold these meetings.

Our balance sheet remains healthy and has been clearly strengthened by the improvement in our investment portfolio. At the same time we have eliminated substantially all remaining goodwill and identified intangibles. Holding company liquidity remains strong with cash and securities at about $82 million.

We expect our annual holding company run rate, interest and operating expenses to be approximately $26 million. Debt-to-cap remains relatively low at 23.5% and as you'll recall we have no debt maturating until 2032. The portfolio's improvement also helps stabilize statutory surplus which stood at $613 million at the end of the third quarter.

September 30 RBC is estimated at 255% down slightly from 260% at June 30. The RBC target for year-end remains 300%. As you know, we have several capital enhancement initiatives underway primarily focused on reinsurance and reduced risk. While life insurance sales in the quarter remain depressed, we continue to develop new relationships with an expanded range of distributors including independent marketing organizations.

Annuity deposits were also down and net flows were negative due primarily to lower deposits partially offset by persistency that was very strong as I mentioned earlier. Our tax story remains complex. Peter will take you through it but simply put, we have $423 million in net deferred tax assets available to offset future tax liabilities.

To sum up, we are encouraged by the improvement in the quarter but the environment and our situation remain challenging. We continue to focus on what we can control as we manage the business and pursue our growth strategy. At the heart of this strategy is leveraging our core capabilities and pursue a sustainable, profitable growth.

As you know this morning we announced the formation of Saybrus Partners, our new distribution company. At the same time we announced the three year agreement with its first client, Edward Jones and Company, to provide life insurance consulting services. We are pleased that a firm with the market presence and creditability of Edward Jones has chosen Saybrus to work with its vast network of financial advisors.

Saybrus is a prime example of our growth strategy and we are encouraged by its early success. We will remain disciplined in pursuing additional growth initiatives that fit with our capabilities. As we make progress we will share it publicly. Again, we are pleased with the quarter's results but acknowledge that much more needs to be done and we're working every day to that end. I'll know turn it over to Peter.

Peter Hofmann

Slide three of the deck shows a summary of the third quarter results. Once again it was a complicated quarter on the surface; however, the underlying results point to stabilization and improvement in our financial position. As Jim mentioned we had a net loss of $26.6 million or $0.23 per share and an operating loss of $2.8 million or $0.02 per share.

Excluding some discrete items, operating income was $33.3 million or $0.29 per share. Those items included a $27 million goodwill impairment related to the carrying value of our private placement subsidiary Philadelphia Financial Group, $18.7 million in write-downs of capitalized expenses.

The largest portion of this is related to IT costs which have been capitalized as we installed a new administrative system but which are not supportable given current sales and product projections, $12.7 million in severance costs and non-deferred sales related costs. I'll cover this in a bit more detail in a moment.

And going the other way, we had a $22.3 million tax benefit related to intra-period tax allocations. As we indicated in prior calls, we expect to have significant noise in our GAAP tax line for some time.

The key business drivers of our third quarter results were as follows. Mortality experience rebounded from the second quarter and was modestly better than long-term expectations. Net investment income improved meaningfully with a recovery, particularly in alternative assets. Surrenders are elevated, but as Jim said, very manageable from a liquidity and capital perspective.

Expense reductions are beginning to have some impact, particularly on a statutory basis where deferrals don't factor into the picture. GAAP and [stat] balance sheet metrics are stabilizing or improving. Lastly, the portfolio is on a positive trajectory driven by continued spread tightening across all sectors. Unrealized losses are down substantially, as are credit impairments, although we continue to be affected by downward rating migration during the quarter.

Slide four shows the trend in operating earnings and book value over the last several quarters, excluding the unusual items in the quarter which amount to $0.31 per share. As I said, operating income was $0.29 per share. Note that this incorporates an effective tax rate of 0%. Given that we continue to have a full valuation allowance against our operating and capital items, we expect to have a 0% effective tax rate over the near term.

Book value per share increased approximately 29% from June 30th driven by appreciation of the investment portfolio and book value per share excluding AOCI decreased reflecting the net loss.

A more detailed earnings summary is shown on slide five. Note that this slide shows the income statement detail excluding the closed block.

Revenues in the open block improved versus the second quarter and reflect the improvement of net investment income and fees, particularly those fees based on asset balances in variable products. Benefits and reserves improved from the second quarter as a result of mortality experience that was modestly better than long-term expectations, declining inforce and lower variable annuity reserves as a result of the equity market improvement during the quarter.

Operating expenses include the $20.7 million of severance and non-deferred sales related expense as shown on the previous slide. DAC amortization was higher than in the second quarter because of improved mortality.

The regulatory closed block remains stable and consistent with the glide path of the block. I'll cover the tax and realized loss line separately in a moment.

First, please turn to the UL and VUL mortality results on slide six. Margins in both of these blocks improved from the second quarter. And as I mentioned on last quarter's call, we expect mortality margins to begin decreasing with lower new business volumes. Our near-term expectations remain approximately 45% in UL and 55% in VUL.

As Jim mentioned earlier, we continue to closely watch persistency. Slide seven shows annualized aggregate surrender rates based on contract value surrendered. Experience can differ significantly by block of business. And C life surrender rates have continued to increase over the past four quarters, but again, remain at manageable levels from a liquidity and capital perspective.

Annuity surrenders are at their lowest levels in many quarters. These tend to be more volatile partly because we include private placement contracts in the measure. Let me reiterate also that from a general account liquidity perspective these numbers do not represent cash out the door.

In many cases, there are loans outstanding against the policies and for more recent business charges are due upon surrender. In addition, the measure also includes separate account surrenders, not just general account surrenders.

Next, let me spend a moment on expenses on slide eight. This slide shows our consolidated statutory expenses adjusted for non-core items such as severance and the software write-offs. We completed our planned staff reductions in the early part of the quarter and are beginning to see the impact of these actions and of lower business volumes on a statutory basis. The fourth quarter we'll see the full run rate impact of the staff reductions.

On a GAAP basis, expenses will decline more slowly than on a statutory basis. The significant portion of the reductions were in new business areas that with higher sales volumes would have been deferred. As it stands, we deferred only $1.4 million of expenses this quarter compared with $5.6 million in the second quarter and $13 million in the first quarter. And none of those numbers include commissions.

We have been reporting non-deferred sales related expenses to you as unusual items over the past three quarters. This was always intended to be a transition. As we move into 2010, we will have reduced our sales related expenses to be in line with our current business volumes.

In addition, we'll have transferred a significant portion of the remaining sales related costs, including over 100 employees out of the insurance entities into our new distribution company. We viewed this expense as an investment in what is a new and promising initiative.

Finally, while we've completed our planned staff reductions, we continue to pursue a variety of non staff related expense reductions, which will benefit us in 2010. Slide nine shows an update of some schedules that we first showed you last quarter. And it's clear our tax situation remains complex.

The most significant factor this quarter was the appreciation of the investment portfolio. This reduced the net EPA and related valuation allowance. And without going into details, this was the source of the $22.3 million tax benefit to operating earnings. The quarter also included a reduction in the DTA related to the spinoff of Vertis but this had no impact on equity or earnings because it was fully offset by a change in the valuation allowance.

As a reminder, GAAP tax valuation allowance does have no bearing on whether deferred tax assets will ultimately be available to reduce taxes. We certainly believe that our tax attributes still have substantial value.

The bottom panel breaks out the details of those attributes, shows that our net operating loss carry-forwards and NOLs, tax credits and capital loss carry-forwards continue to be fully offset by valuation allowances. It also underscores again that substantial time remains for us to ultimately recognize these benefits.

Let's move to the realized losses on slide 10. Chris will cover the impairments and transaction losses, which as you can see continue to improve meaningfully. Let me comment just briefly on our variable annuity hedging program.

The hedging program continued to perform well in the quarter, with a $4 million economic hedge loss more than offset by the change in the GAAP liability due to the FAS 157 non-performance risk factor. Year-to-date, our loss on an economic basis is $3.4 million.

Finally, a summary of our balance sheet metrics is shown on slide 11. Leverage remains modest at 23.5%. We've continued to repurchase our debt in the open market. Through the third quarter, we've effectively retired $40.5 million PAR of our $300 million senior debt issue.

Holding company liquidity was $82.3 million in cash and securities as of September 30th. With a $27 million impairment and other write-downs this quarter, we substantially eliminated goodwill and intent identified intangibles on the balance sheet.

Remaining capitalized items, not including deferred acquisition costs total approximately $36 million as of September 30th and consists mostly of capitalized IT costs. And speaking of DAC, we will be conducting a full review of all DAC assumptions in the fourth quarter.

Statutory surplus of $613 million for Phoenix Life is down modestly from June 30. RBC was once again heavily affected by rating downgrades in the bond portfolio. However, key committees of the NAIC have approved a re-rating of RBDS. And we've estimated the impact of this new rating methodology on the RBC for Phoenix Life partially offsetting the impact of downgrades and bringing our RBC ratio to an estimated 255%.

The impact of this estimate was 12 percentage point on the RBC that we're showing here. Our target for the year remains at 300% and as Jim mentioned, our focus continues to be on reinsurance, optimizing internal capital management and reducing risk in order to achieve that target.

And with that, let me turn it over to Chris.

Chris Wilkos

Thanks, Peter. As Jim has described, investment markets rebounded strongly in the third quarter and the Phoenix portfolio benefited greatly from that rebound. Let's start with net investment income on slide 12, consolidated net investment income increased by $6.5 million from the second quarter to the third quarter, the second consecutive quarterly increase in net investment income.

The increase in investment income was attributable to a sharp rebound in the performance of alternative investment assets. Income from these assets jumped to a positive $4.5 million in the quarter, after producing a negative $19.5 million result in the second quarter and an even larger loss in the first quarter.

Alternative investments have rebounded alongside improvements in the equity and debt markets. Encouragingly for the Phoenix portfolio because of the one quarter lag in partnership accounting, improvements in alternative returns have not yet fully materialized through our income statement. Due this lag effect, we expect continued improvement in the fourth quarter.

Open block investment income decreased by $2 million in the period. Net of the surrender of an old corporate-owned life insurance case by a distressed financial institution, NAI would have increased by $6 million. The lost income on the old [Coley] case was largely offset by the credited interest no longer payable on these policies.

Closed block investment income increased by $8.6 million in the quarter, again, driven by higher alternative investment returns. Slide 13 provides more detail on the improvement in alternative asset performance.

Returns were negative in the fourth quarter of 2008 and declined further in early '09. As I described on the previous slide, we have seen a substantial rebound since the first quarter. In fact, without the impairment to the only joint venture real estate partnership that we hold, alternative net investment income would have been even stronger.

Venture capital in mezzanine funds have been an area of strong investment performance for Phoenix over many years and after a period of negative returns, we appear to be on an upward trajectory for improved performance.

Slide 14 describes third quarter credit impairments by sector compared to results for the last three periods. Credit impairments declined sequentially for the third straight period, dropping to $14.9 million from $20.9 million in the second quarter.

The moderation in debt impairments reflects the strength in fixed income markets with improving spread levels, significantly greater liquidity and stronger issuance. During the quarter, impairments occurred primarily in collateralized loan obligations and all [to-date] mortgage-backed securities.

We also impaired some direct private equity holdings. Corporate bond impairments were minimal, although we realized about $2.6 million of losses through the sale of a distressed corporate credit. Our private placement bond portfolio, which comprises almost 30% of our fixed income assets, had minimal impairments during the quarter, reflecting the benefits of covenants and other protection inherent in these securities.

In spite of market concerns about commercial real estate, our CMBS portfolio has held up very well and we have suffered minimal impairments in this category of bonds. We also have almost no exposure to direct commercial mortgage loans and therefore do not have any impairments in that category.

Slide 15 illustrates the dramatic improvement in unrealized losses in the Phoenix Fixed Income portfolio. With tightening credit spreads in all sectors, unrealized losses declined sequentially by almost $670 million, dropping the total to just over $400 million of net unrealized losses or less than 4% of the total book value of the portfolio.

The third quarter improvement continues the trend that began in the first quarter, when the extreme fear and pessimism that created distressed valuations and high liquidity premiums at year-end began to subside.

We've estimated our portfolio appreciated by slightly over $50 million in October, dropping the net unrealized loss to about $350 million. Year-to-date we've seen unrealized losses decrease by over 75% of the year-end total. In terms of our focus on a healthy balance sheet, the improvement in portfolio valuations has been a contributing factor in strengthening our balance sheet and stabilizing surplus.

Fifty-six percent of the gross unrealized losses are attributable to investment-grade rated securities which have extremely low historical default rates. Only 26% of the gross unrealized losses are attributable to securities rated B or below. This trend in lower unrealized losses has substantially increased the liquidity of our assets, as the majority of securities can now be traded at prices that are at or exceed their accounting values. This will reduce our need to hold more highly liquid assets which are often at low yields.

On slide 17, the impact of continued significant market downgrade activity has been to increase our portfolio's percentage of below investment-grade bonds to over 11% of total bonds, from 10.6 at the end of the second quarter. A portion of this increase was attributable to the significant appreciation and below investment grade markets during the quarter, which increased the value of existing below investment grade holdings relatively more than in the overall portfolio increase.

This result is above the top of our allocation range for high-yield bonds. The majority of the increase in below investment grade exposure occurred in structured credit, primarily CLOs and residential mortgage-backed securities. Rating downgrades in these two sectors have been significant and widespread; however ,over half our below investment grade allocation is rated NAIC-3 or BB which is positive, since historically BB default rates are a fraction of the overall high yield default rate.

We have several initiatives underway to reduce below investment grade exposure and increase the quality of existing below investment grade bonds. These initiatives include selling appreciated high-yield bonds and exploring alternatives to reduce the RBC charges on CLOs and other asset-backed securities.

We estimate that the recently-approved NAIC ratings modification will have a beneficial impact on up to 200 million super senior and senior RMBS securities that currently are rated in the lower tiers of below investment grade in our portfolio. On a positive note, the number and amount of downgrades to below investment grade slowed substantially during the month of October.

Slide 17 provides an update on liquidity in our portfolio at quarter end. During the last half of 2008 and first half of 2009, we believe that having ample liquidity was an essential priority given the severe recession and credit market freeze. In that period, we increased the percentage of our investments in two highly-liquid market segments.

We increased our short-term cash and Treasury position and doubled our allocation to agency mortgage-backed securities, which are both high quality and extremely liquid. The net effect of our actions has been to more than double liquidity form a normal 5% allocation to over 12% at quarter end.

Given the improved liquidity in the fixed income markets and the appreciation in our portfolio values, we began reducing our liquidity position during the last part of the third quarter. We are currently moving towards a 10% liquidity target. That percentage would be about where our liquidity metric was at the end of the first quarter of 2009.

In Q3 we did redeploy a large portion of our cash and short-term position into agency mortgage-backed securities, a move that resulted in a yield pickup of about 450 basis points on over $300 million that was reallocated.

Slide 18 summarizes our non-agency residential mortgage holdings by borrower type, credit quality, vintage and collateral type, the factors that drive the ultimate performance of RMBS. While we have had some rating downgrades, in particular in the Alt A category, not much has changed in our mortgage backed securities portfolio in the last several quarters. The Phoenix RMBS portfolio remains high quality, seasoned and it has a substantially higher amount of fixed-rate mortgages compared to the market.

We believe these factors drive relative performance and the percentage of delinquent loans in our MBS holdings is about half of the market delinquency rates for each of the market categories in this table.

Slide 19 shows a snapshot of our CMBS portfolio. There has also been little change during the last several quarters. Our holdings are very high quality and seasoned, with a significant percentage of loans originated in 2004 and earlier. Even after extensive rating downgrades, 98% of our CMBS bonds are rated A or higher. This speaks to the careful construction of this piece of the portfolio and our unwillingness to invest as underwriting standards weakened.

Now I'll turn it back over to Jim.

Jim Wehr

Thanks, Chris. We'll now open it up for questions. Barb, can you remind everyone how that will work?

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from Bob Glasspiegel – Langen McAlenney.

Bob Glasspiegel – Langen McAlenney

Thank you. One clarification, didn't quite follow whether the RMBS rating change was reflected in the current RBC ratio you gave, or will be reflected? I got lost on the 12%.

Chris Wilkos

It is reflected, Bob.

Bob Glasspiegel – Langen McAlenney

And so it would have been what, without it?

Chris Wilkos

Twelve points less.

Bob Glasspiegel – Langen McAlenney

How many points?

Chris Wilkos

Twelve points.

Jim Wehr

Q3, Bob.

Chris Wilkos

Q3.

Bob Glasspiegel – Langen McAlenney

And remind me how big the closed block represents relative to the company today with respect to either capital – I guess it's about 58% of investments, but when you think about your sort of core run rate operating earnings, how important is the closed block?

Chris Wilkos

Well, on a GAAP basis, you can see it on the summary slide on page –

Bob Glasspiegel – Langen McAlenney

Six?

Chris Wilkos

Five. And you can see the closed block has about 15.5 million of quarterly GAAP earnings emerging. Now the point there is that there are no expenses charged against that earning stream because expenses are not part of the closed block. That'll give you a sense for how it contributes to the bottom line.

Bob Glasspiegel – Langen McAlenney

How about capital allocation?

Chris Wilkos

Capital allocation, we haven't provided a specific breakout. We do allocate – as against all product lines – at a 300% RBC capital level.

Bob Glasspiegel – Langen McAlenney

So I mean it's well over 100% of core earnings today, right?

Chris Wilkos

No. Again, there are no expenses against that block, so –

Bob Glasspiegel – Langen McAlenney

You want to put the interest expense on it. Is there corporate – I guess there should be some corporate allocation as well?

Chris Wilkos

There's – yes, there's operating expense that's supported by those earnings, so I wouldn't call – certainly wouldn't put it north of 100.

Operator

Our next question comes from Jimmy Bhullar – JP Morgan.

Jimmy Bhullar – JP Morgan

Hi. Thank you. I had a couple of questions. The first one is just on your earnings. In your release, you quantified sort of the X unusuals earnings number to be about $0.29. I just wanted to get an idea, is that a number you expect to repeat going forward or it's somewhere in that neighborhood, assuming that everything's normal? Because there are things this quarter that I would not consider being run rate even though they weren't mentioned, like mortality was pretty good, net investment income might stay high through the fourth quarter but certainly doesn't seem like it'll stay this high through next year.

Your VA expenses were pretty low. So I just wanted to get an idea to the extent you can on what you considered your run rate earnings to be or how that $0.29 number moves up or down over the next few quarters.

And then secondly, just had a question on – you are doing a DAC recoverability review in – or DAC review in the fourth quarter. Just your thoughts on DAC recoverability given that your sales have been pretty weak recently and withdrawals – even though it may be manageable, but have been picking up. So just wanted to get an idea of what you think about that?

Chris Wilkos

Sure, and this is with the understanding that we obviously don't provide specifics on these items –

Jimmy Bhullar – JP Morgan

Sure. Yes, yes.

Chris Wilkos

But I'll give you some of our thinking around both those topics.

Jimmy Bhullar – JP Morgan

And the reason I'm asking is because if we look at that $0.29 number that you mentioned, it's been considerably lower in the past. So I'm just trying to see – has the business really improved that much, or are there things that weren't quantified in that $0.29 and just get an idea on what your views are going forward.

Chris Wilkos

I think we've identified the major unusual items here. There are a couple of things going on. One, obviously is, as I mentioned, there's a 0% effective tax rate given that the losses that we recorded over the last several quarters have, to a large degree, been driven by our putting up valuation allowances against deferred tax assets. And so we basically don't expect to have GAAP tax expense on a core basis, although some of the inter-period allocation rules can and did create noise, but we backed that out here.

The second item clearly this quarter that was above, I think, anybody's expectation was the equity markets, and I would say that's an area as it affects both the fee levels and the DAC amortization that unless the markets continue at their current pace, that would not be repeatable on a quarter-to-quarter basis.

From a mortality perspective, again, as we said, we think it's a modestly positive quarter but not a hugely – I wouldn't back anything out for that. And the surrender picture is, while it's elevated, not a major driver of the GAAP earnings from quarter-to-quarter.

So without sort of putting a pin into a specific quarterly run rate number, there are clearly a couple of items here that over the long term we wouldn't view as sustainable, those being the 0% tax rate and the strength of the markets.

But at the same time I think we're seeing the core earnings in terms of investment income mortality margins from our inforce emerging and being helped by the expense reductions that we've taken.

Jim Wehr

And Jimmy, I think one other item just to kind of counter your observation that kind of most of the unusual items kind of broke in our favor, the alternative investment income number, while it was improved, was still below our long-term averages and our long-term expectations. So that's one that probably has more upside as the markets continue to normalize.

Peter Hofmann

Let me turn to the questions on the DAC assessment. First of all, just to be clear, we do asses our GAAP assumptions every quarter as we're required to. Clearly, we can't do a full actuarial analysis with experience that isn't so on every quarter, so we do spend a lot more time in the fourth quarter really drilling down into each of the blocks. But every quarter, including this quarter, we look at whether the emerging experience warrants an unlocking of the assumptions and it did not this quarter.

I think you identified some of the areas that we'll need to look at carefully. The key assumptions are going to be around surrenders, around mortality, around the level of renewal premium, but all of these affect the inforce business a lot less than I think your question was whether there's an impact from no new business being written.

The DAC assessment really is on the inforce business and the assumptions that apply to the policies that are already on our books and are not affected by projections of new sales. So the sales picture really doesn't factor significantly into the DAC assumption of [inaudible].

Jim Wehr

And during the periods of low sales, we've been purposely not capitalizing very much of the sales expenses. We've been building up balances during the period's low sales that would be difficult to recover based upon the margins of the business that was written.

Jimmy Bhullar – JP Morgan

My point was more that because the sales had been low, to the extent you've been deferring, you might not be able to keep those on the balance sheet.

Peter Hofmann

But that's why, as I said, we've been reporting to you over the last several quarters, the non-deferred sales-related costs. So we have not been deferring over and above what's supportable by the buying of business that we're writing.

So I can't sit here today and handicap for you how the DAC unlocking analysis will break. There's some positives. Long term we've generally had mortality be better than expected. The surrender picture recently clearly is a bit worse than we would have expected. But how that all shakes out when you literally go through block by block is something we're going to have to report to you in February or year-end.

Operator

Your next question comes from Eric Berg – Barclays Capital.

Eric Berg – Barclays Capital

Peter described the quarter as a complex or complicated one and Jim, you began your comments by saying, I think you said, turning the corner. Understanding that there were many, many developments in the quarter on many fronts, if you were to highlight or identify or hone in on the measures that you think best speak to Phoenix's turning the corner, what would you focus on in terms of everything you've talked to us about today? What best speaks to in your opinion Phoenix's turning the corner?

Jim Wehr

Eric, I'd probably focus on three items, the most important being the general improvement in our core operating results. And I think we covered that pretty fully. I think the improvement in our investment portfolio and the resulting improvement and strengthening of both our balance sheet and the benefit we've gotten in the income statement from that improvement are both fairly apparent.

And I think the third item is around the fact that we've started to make some progress on our growth initiatives, the announcement of our distribution company, Saybrus, the fact that we've signed up a very well-regarded partner in the form of Edward Jones. And Saybrus is new, brand new to this group. We announced it this morning. And I thought from that prospect that I might share what we think are a couple of benefits that come from that business.

First, it leverages our demonstrated wholesaling capability, something that we've utilized for a long time, selling our existing products and working with others in partnership. It allows us to utilize a resource that was significantly underutilized, given our current level of sales. So I think it's smart from that perspective. The financials of the business are interesting. It's a, because of the nature of the business, we're just basically transactional.

We're not selling Phoenix products in terms of the Edward Jones relationship, so there's a very modest capital commitment. Our revenues and profits are more front end loaded than our traditional business. And expenses, because they are largely commissions, are variable. So it's a variable cost model.

And then finally and I think this is very important because of all of the potential growth initiatives we're considering and the importance of partnerships and finding viable partners and well-regarded partners, the fact that Edward Jones was willing to make a commitment to work with Phoenix we think is very important in the marketplace and should have some knock on effect as we have conversations with other prospective partners.

So I'd kind of focus, Eric, on those three aspects.

Eric Berg – Barclays Capital

That was very helpful. My second and final question indeed relates to Saybrus. Consider the two companies that you mentioned that Saybrus will be working with at Edward Jones, namely John Hancock and Pacific Life. Help us understand, try to take us from the abstract to the concrete by helping us understand exactly what the consultants will be doing in connection with these two competing insurance carriers.

And in particular, why wouldn't Hancock, Manulife life and Pacific Life, why wouldn't they be wholesaling their own products into Jones?

Jim Wehr

Well, let me first explain how it's going to work. And then try and give a response to the second part of the question, although I think frankly some of the response to that question is better asked of Edward Jones than Phoenix. But let me start and explain first of all kind of how it's going to work. And I think it's a good question.

First, is we're going to be working with the Edward Jones distribution folks. So they've got 12,000 or so financial advisors spread across the country. Our wholesalers are going to be working with those Jones financial advisors in an assisted sales model.

So they're basically going to be working in partnership with our financial advisors, bringing our capabilities in the high net worth space, both in life products and annuity products. And they're going to be selling in partnership in tandem if you will, with the Jones folks. They're going to be selling both Hancock products and Pac Life products. So it's really going to be our folks working in partnership on the distribution side with the Jones advisors selling Hancock and Pac Life products.

To the second part of the question why Phoenix and why not the Pac Life and Hancock advisors, in Edward Jones' opinion, they felt that the capabilities we brought to the marketplace, the demonstrated capabilities having sold both our own products and sold products through the State Farm distribution network that they had capabilities that they valued and they thought could enhance their distribution capability.

Operator

Your next question comes from Steven Schwartz – Raymond James & Associates.

Steven Schwartz – Raymond James & Associates

I actually wanted to ask how Saybrus was going to work?

Jim Wehr

Hopefully you still don't have that question.

Steven Schwartz – Raymond James & Associates

Well, I think I understand it better, so thank you Eric.

Jim Wehr

Okay.

Steven Schwartz – Raymond James & Associates

You're going to get – who's going to pay you?

Peter Hofmann

It'll come out of the compensation that's paid from the distributor to the carrier.

Steven Schwartz – Raymond James & Associates

So it's, wait a minute, it's going to come from Hancock or Pac Life.

Peter Hofmann

Yes, it's that distribution allowance that it split.

Steven Schwartz – Raymond James & Associates

Okay, that's good. And presumably maybe Edward D. Jones' thought here is that you can be a fair arbiter?

[Phil Polkinghorn]

In what regard, Steve?

Steven Schwartz – Raymond James & Associates

Well, in regards to the Hancock guy's going to push the Hancock, the Pac Life guy's going to push the Pac Life product.

[Phil Polkinghorn]

Oh, in terms of our guys will be providing solutions to their clients as opposed to having a particular axe to grind.

Steven Schwartz – Raymond James & Associates

Right.

[Phil Polkinghorn]

I think that may be a secondary consideration and may be important. But the primary focus I think was, around Jim's comments around the demonstrability they had helping an advisor with a high network clientele go through their client base and help bring very sophisticated life insurance solutions to bear.

Steven Schwartz – Raymond James & Associates

And if I can just, if I can stay on Saybrus for a second and where you're all going, is Phoenix becoming an NMO with the legacy block of insurance business?

[Phil Polkinghorn]

No, it's not. But we had opportunities to deploy some of the skill sets and capabilities that we had. And some of them lend themselves to very quick deployment, right? I mean, take these capabilities and assist the tails and deploy them to sell products that already exist in the marketplace with an advisor base that's already there and the clientele that's already there.

Phoenix on our own paper is having to admittedly pivot and look at different distribution outlets, perhaps in some cases maybe some different products. And those things are not as quick to implement because in some cases they involve identifying another distribution partner, getting to know one another, negotiating and perhaps in some cases even developing or getting approved a new product.

So it's certainly an add-on to the regular insurance business and has some nice attributes that Jim mentioned in that we get revenues without taking a whole lot of risk based capital. So it's different in that regard. But it's deploying the capabilities that we always had in a different way. And it's in addition to the insurance business, not necessarily instead of.

Steven Schwartz – Raymond James & Associates

All right, if I could just ask three quickies now. Peter, was there – I couldn't figure it out – was there a DAC adjustment in the quarter for the equity markets or not?

Peter Hofmann

No, not an explicit adjustment. There was substantially lower amortization in the annuity line similar to last quarter.

Steven Schwartz – Raymond James & Associates

And that reflected what? I mean the markets are up, profitability is up, doesn't DAC amortization go up?

Peter Hofmann

No.

Steven Schwartz – Raymond James & Associates

No.

Peter Hofmann

No, it was lower amortization and lower reserves.

Steven Schwartz – Raymond James & Associates

Oh, okay. And then –

Jim Wehr

Steven, I'm going to have to cut you off. If you want to jump back in queue we can hopefully pick you up at the end but we do have some other folks and I – they've been very respectful about asking just two questions, so we'll be happy to get back to you if we have time.

Steven Schwartz – Raymond James & Associates

Not a problem, Jim.

Jim Wehr

Thank you. We'll take the next question.

Operator

Our next question comes from Amanda Lynam – Goldman Sachs.

Amanda Lynam – Goldman Sachs

Hi, thank you. I was hoping you could give us an update on where you envision trends for statutory earnings heading into next year. Obviously, you've provided the year-to-date number in your presentation but just interested in where you'd see things headed for the fourth quarter and into 2010?

Peter Hofmann

Again, without giving specific earnings guidance, just a couple of items, one is clearly to the degree the investment portfolio kicks out higher earnings that's a positive both on a GAAP and statutory basis. The fact that we are not selling a lot of new business, as you can well imagine, results in a substantial reduction of surplus strain going forward.

So that will help statutory earnings going into 2010 and the expense reductions also come through more directly as I mentioned on a statutory basis because the deferral issue never factors into the picture. So I think –

Jim Wehr

And as we've said, those will show up more fully in the fourth quarter.

Peter Hofmann

Fourth quarter and [going into] 2010.

Operator

Your next question comes from Bob Glasspiegel – Langen McAlenney.

Bob Glasspiegel – Langen McAlenney

One last question on Saybrus, could you give us some size, how many people do you have associated with this unit, how big? I assume it'll be fee revenue that'll be coming through but when do you think you'll be able to break out if you execute your plan, this unit so that we can track the success?

Jim Wehr

Well, the headcount of Saybrus is about 100 employees and in terms of revenues and earnings, the revenues should start to show up fairly quickly as we move into 2010. And obviously, Bob, it'll be a function of the level of business that we can write through that partnership combination I referenced earlier.

But the – and then the earnings associated with that, given it's a variable cost model and it doesn't have the upfront capital commitment that our traditional products have should materialize more quickly. And that kind of gets back to the earlier response that Phil gave around one of the attributes of this business is, because it's a capability we already have in place and the nature of the revenues and the earnings are a little more front end loaded than our traditional business. We think it's a nice complement to our traditional or existing business.

Bob Glasspiegel – Langen McAlenney

Okay, good answer. Are these 100 people just going to be doing Saybrus or are they also supporting existing relationships as well?

Jim Wehr

That's a good question. We should've been clear there. They are also going to be selling Phoenix products and ultimately they have the potential to work with other potential partners beyond Edward Jones.

Bob Glasspiegel – Langen McAlenney

Am I allowed one more follow-up or should I go back in the queue?

Jim Wehr

I think you can take one more.

Bob Glasspiegel – Langen McAlenney

Thank you for your generosity. Is there some reluctance for these – for Hancock, etc to open up their books to someone that's competing against them? I know you're not competing for new sales but is that going to hurt an open relationship with these companies as you are marketing to the companies, to Jones?

Jim Wehr

Well I think in some respects that might be a better question to ask those folks. But clearly they signed on with Jones' model. Jones put this model together, and frankly they may have preferred to provide the wholesaling themselves, but Jones felt that this was the best combination for reasons that we've shared and I think some others brought up on the call. And they signed on so they seem to be okay with it.

Peter Hofmann

I think ultimately if it's successful everybody wins, right? If the sales through the distribution channel increase significantly the carrier, the distributor and Saybrus all benefit. And I think that's –

Jim Wehr

I think that's a good way to look at it.

Operator

Your next question comes from Steven Schwartz – Raymond James.

Steven Schwartz – Raymond James & Associates

Hi, just a quickie on the follow-up. Chris, you invested $300 million of cash and liquidity, you've got $300 million more to go, is that correct?

Chris Wilkos

Yes, we're going to bring the total liquidity position down to 10% of the total, so that will involve investing several hundred million up to $300 million.

Operator

Your next question is from the line of Eric Berg – Barclays Capital.

Eric Berg – Barclays Capital

Thanks, two follow-up questions. First, I didn't quite follow, what are your plans if any to reduce the percentage of the low investment grade holdings in structured finance?

And secondly, with respect to the 12-point RBC pick-up that you enjoyed as a result of your implementing the new rules regarding the RBC requirements for residential mortgage-backed securities, does this pre-suppose, does your implementing this new rule presuppose that it's going to go through or just to get my facts straight, has the new rules already gone through and there is no question but that you will be permitted to use these new rules on the 2009 statement?

Peter Hofmann

I'll let Chris address the below investment grade. But in terms of the rules, they, as far as we know, have not obtained final approval; however, we're – all indications we're getting is that it's highly likely that they will approve.

Chris Wilkos

On the below investment grade front, again, the easiest lever for us to pull is to sell securities and given the appreciation that we've seen in high yield markets, a fair percentage of our below investment grade holdings are within a tolerable percentage of their book value if not at their book value. So that would be one of the first things we would do.

On the structured securities front, I've mentioned in previous calls that we have a number of different bonds that because of the NAIC requirements to go to the lower of two ratings, that in certain cases getting a third rating agency involved will cause the rating to go up if that third agency is between the first two. So that would be a situation where we think the capital charge that we have allocated is too high and we can potentially reduce it.

It's not necessarily a means of reducing below investment grade holdings, but certainly it's a means of improving our RBC ratio. There are some potential sales in the structured portfolio but those are fairly limited. And then, clearly there's other capital market structures that are out there that we're looking at that may or may not have some applicability in terms of further reducing below investment grade.

Eric Berg – Barclays Capital

But with respect to – if I could just quickly follow up, I know we're trying to keep to two, but just really quickly, how would this bringing in of a third rating agency work in the sense that, isn't it traditionally the case that when securities are rated it is the issuer that pays not the – I mean wouldn't it be unusual for an investor to pay to have a security rated or would that not be unusual?

Chris Wilkos

Well I think it is unusual because again, the deals were originally rated at the time of issuance and we're exploring opportunities to do this with rating agencies. It is, I would characterize it as unusual and not unprecedented and not necessarily something that can't be done.

Operator

And thank you, that concludes our question-and-answer session. I'd like to now turn the meeting back over to Jim.

Jim Wehr

Well, we'd like to thank everybody for their time this afternoon. The questions I thought were very good questions, kind of focused on the key issues in our business, and we thank everybody for their time and attention. Have a good afternoon.

Operator

And that concludes today's call. Please disconnect your line at this time.

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